Late Trading Scheme Constitutes Deceptive Conduct Under the Exchange Act

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Susan M. Greenwood | Bloomberg Law VanCook v. SEC, No. 10-00031, 2011 BL 205289 (2d Cir. Aug. 8, 2011) The U.S. Court of Appeals for the Second Circuit denied John Joseph VanCook's petition for review of a Securities and Exchange Commission (SEC) order upholding an administrative law judge's (ALJ) findings that he violated Sections 10(b) and 17(a)(1) of the Securities Exchange Act of 1934 (Exchange Act) and Rules 10b-5 and 17a-3(a)(6) thereunder. The Court further affirmed the imposition of sanctions.

Orchestrating a Late Trading Scheme

As the Second Circuit explained, stockbroker VanCook joined Pritchard Capital Partners LLC (Pritchard Capital) in 2001 to open a New York office for the firm. Specifically, VanCook was tasked with "attract[ing] new, mutual-fund-trading hedge-funds to the firm." VanCook succeeded in this mission, but also allegedly orchestrated a late trading scheme for select hedge fund clients. Pritchard Capital, the Second Circuit continued, acted as an introducing broker and did not "'handle[] the mechanics of order entry, confirmation, clearance of trades, calculation of margin, [or] similar activities.'" Instead, it engaged the services of a clearing broker. When VanCook joined Pritchard Capital, Bear Stearns acted as its clearing broker. VanCook, however, soon made a change and Banc of America Securities (BOA) replaced Bear Stearns. The switch, the Court explained, helped foster VanCook's alleged scheme. It explained that mutual funds calculate the net asset value (NAV) of their shares by 4:00 P.M. when U.S. stock markets close. Mutual fund investors must submit transaction orders by 4:00 P.M. in order to receive that day's NAV. Allowing orders past 4:00 P.M. gives investors an unfair advantage as they can consider after-market information. According to the Court, Bear Stearns strictly enforced the 4:00 P.M. order rule. BOA, however, used an automated Mutual Fund Routing System (MFRS) that accepted orders entered until 5:30 P.M. Although BOA required that "'orders should be received and time stamped by the close of the NYSE 4 PM EST,'" VanCook allegedly "exploit[ed]" an MFRS "loophole" that permitted orders entered before 4:00 PM to be edited until 5:15 PM. As such, VanCook allegedly time-stamped "tentative" orders before 4:00 PM and finalized them after his clients determined whether the trades would be profitable based on the daily NAV calculations. Following this scheme, VanCook purportedly allowed three hedge funds to execute close to 5,000 late trades. As a result, the hedge funds profited and VanCook's compensation increased from $180,000 in 2001 to $800,000 in 2003.

Deceptive Conduct

On appeal, the Second Circuit agreed with the SEC and ALJ that VanCook's late trading scheme constituted deceptive conduct. It rejected VanCook's characterization that he was only "associated" with the scheme and his submission of trade orders after 4:00 P.M. was insufficient to establish liability. Calling VanCook the "architect" of the scheme, the Court noted that he (1) secured BOA as Pritchard Capital's clearing broker to take advantage of MFRS, (2) time-stamped trade orders in advance of clients' final decisions, and (3) falsely informed Pritchard Capital's majority owner that he was not accepting orders after 4:00 P.M. Moreover, the Second Circuit held that VanCook's late trading scheme "'incorporate[d] an implicit misrepresentation' by 'falsely mak[ing] it appear that the orders were received by the intermediary before [4:00 p.m.] when in fact they were received after that time.'" Such an implied misrepresentation, the Court concluded, violates Exchange Act Section 10(b) and Rule 10b-5 thereunder.

Recordkeeping Violations

According to the Second Circuit, VanCook's assertion that he is not liable for aiding and abetting violations of the Exchange Act's recordkeeping provisions "borders on the frivolous." "Pritchard Capital's recordkeeping violations resulted directly from the late-trading scheme that VanCook himself designed," the Court said. Because VanCook himself "failed to record the actual times that final trading instructions arrived from the late-trading customers," the Second Circuit concluded that there was sufficient evidence to find that VanCook had "actual knowledge that the firm's records were inaccurate," and, thus, "deliberately" aided and abetted Pritchard Capital's recordkeeping violations.

No Due Process Violations

The SEC permanently barred VanCook from associating with any broker, dealer, or registered investment company; ordered disgorgement of $533,234.01, plus interest; and imposed a $100,000 civil penalty. Although it has "sometimes 'refused, on due process grounds, to defer to the SEC's imposition of sanctions where 'doing so would penalize an individual who has not received fair notice of a regulatory violation','" the Court found no reason to alter the SEC's sanctions. VanCook, the Second Circuit continued, had "extensive experience" in the securities industry, understood the NAV calculation process, and deliberately embarked on a late trading scheme. VanCook also ignored red flags identifying his illegal conduct including (1) guidelines from mutual funds and BOA, and (2) warnings from attorneys for a mutual fund client and for Pritchard Capital. Accordingly, he had notice of his regulatory violations and there was "no reason that the SEC should have limited the amount of disgorgement. . . ." Similarly, the civil penalty was not excessive given VanCook's conduct.
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